I've been studying this issue extensively for
several years now, and have carefully read/watched many or most of the biggest books,
papers,
articles,
posts,
and videos.
I'm interested in it for many reasons; concerned and hopeful citizen and
father, businessman, entrepreneur, investor, economist, and science and
technology enthusiast. But also because my main career is in personal finance.
And there is a significant possibility that this technological advance will
decimate personal financial security for most Americans, at least without
strong and smart policy responses.

The impetus for this particular post is Berkeley
economist Brad DeLong's "Peak
Horse" post last September. I agree with what Brad says. But I'd like
to add the following:

A big issue is not just will machines – robots,
artificial intelligence or advanced computers – replace humans, substitute for
them, but will they be able to inexpensively do so much of what low and medium
skilled and educated humans can do, that they have a great effect on the supply
and demand, and thus the market wage. And will that market wage drop below
minimum for more and more of the population – those with less skill than
average, or no college degree; or next, not even no college degree, but not one
from a major nationally-recognized university; less health and endurance, less
youth, good looks, attractive personality, clean record, etc. Will the market
wage drop below minimum for more and more of these people? For 10% of the
population, then for 20%, then 30%, 40%, 50%, 60%,… What then?

And, has it largely happened already?

Yes, has it happened already, at least to a large
extent? Not just in some theoretical debated future. Please stay with me for
the evidence, which may really surprise you.

You go into a grocery store. In 10 or 20 years
will 90+% of those jobs be gone. Will there be very advanced cameras throughout
the store, connected to a computer with amazing machine learning and other
artificial intelligence (AI). And that computer is connected to the cloud where
it learns from similar computers at grocery stores around the world,
constantly, from their experiences, and their learning, with constant updates.

And what is it learning? How to correctly identify
everything you put in your shopping cart with its machine eyes (as well as how
to detect stealing).

You go to check out. No cashiers. The computer recognizes
you, and everything in your cart, and says, “That will be $127.49 Mr. Delong. Would
you like to pay with your Amazon Visa like last time?”

The (mechanized, computer driven) cart docks at a
conveyer, and robots with amazing dexterity and speed bag up your groceries and
call up your computer-driven car. Then, your mechanized cart (which you didn't
have to push or steer. It stayed with you.) goes to your car, and robots load
the bags in. The shelves are
stocked by robots, and most janitorial and other functions are done by them
too. And if you read The
Second Machine Age, Rise
of the Robots, or just out, The
Master Algorithm, you’ll see that robots aren’t that far from a lot of this
even now. And solar, at least in the sunbelt (reporting from Tucson), powers
all these machines relatively inexpensively. The roof of the supermarket is
covered with solar panels, and the parking lot is shaded completely with solar
paneled canopies – This kind of thing is not that rare even today
in Tucson, and Moore’s
law in solar is only
accelerating after more than a generation. The sun food for the machines
is, and especially will be, a whole lot cheaper than the farmed food for the
humans.

All those low skilled supermarket jobs reduced to
just a human manager, and maybe a few humans, if that, to fill in the gaps. And
the same for restaurants, factories, janitorial and maid service,… I find it
very hard to think of what jobs those low-skilled people will get instead, in
anywhere close to equal numbers to those lost, where those who still have jobs
and wealth will want to pay at least minimum wage for their services.

How many people are going to want to pay a maid to
sweep, vacuum, and mop their floors, when for a tiny fraction of the annual
price they can buy a robotic machine that can plug itself in and manage its
cord, so that it’s no anemic baby-battery Roomba, but a full powered plugged-in
machine, exactly like the one a maid would push and guide.

How many people today want to pay the
“minimum”, or subsistence, wage for a horse, rather than buy a car, or a
tractor, or take the subway, train, or a plane? Not enough to employ even a tenth of one percent of the horses we had a hundred years ago.

Now, is this all just a theoretical debated
future?

No, not at all, because if you look at the data,
it's happened already, to a large extent. We're already well along. The
statistics I'm about to give you are from MIT economist Michael Greenstone and
Brookings senior fellow Adam Looney in a
2011 Milken Institute Review article:

1) "Between 1960 and 2009, the share of men [age
25 – 64] without any formal labor-market earnings for an entire calendar year rose from 6 percent to 18
percent." (page 11)

2) "The percentage of men working full time [age
25 – 64] has decreased from 83 percent to 66 percent over the same period."
(page 12)

3) "Nonemployment for an entire calendar year among men without high
school diplomas [age 25 – 64] increased by 23 percentage points (from 11 to 34
percent) and among those with only a high school degree by 18 percentage points
(from 4 to 22 percent)". (page 12)

4) "One way to untangle the two phenomena is
to examine the median earnings among all working-age men – this time including
those who earn nothing at all. What appeared as stagnant earnings for workers
is really an outright decline in wages for the median men of working age. The
median wage of the American male has declined by almost $13,000 after
accounting for inflation in the four decades since 1969. (Using a different
measure of inflation suggests a smaller, but still substantial, drop in
earnings.) Indeed, earnings haven’t been this low since Ike was president and
Marshal Dillon was keeping the peace in Dodge City." (page 12)

5) "Consider just men between the ages of 30
and 50, a group for whom retirement is rare. The median earnings of all men in
this group declined by 27 percent between 1969 and 2009, which is nearly
identical to the 28 percent decline for those who are 25 to 64 years old."
(page 12)

6) "Surely, the most astonishing statistic to
be gleaned from the trend data is the deterioration in the market outcomes for
men with less than a high school education. The median earnings of all men in
this category have declined by 66 percent [not a misprint] [from 1969 to 2009].
At the same time, this group has experienced a 23 percentage point decline in
the probability of having any labor-market earnings. Roughly 10 percentage
points of the 23 percentage points is attributable to the fact that more men
are reporting disabilities, even though work in physically demanding jobs has
been declining for many decades. Men with just a high school diploma did only
marginally better. Their wages declined by 47 percent and their participation
in the labor force fell by 18 percentage points." (page 13)

Now, it's true that all of these statistics are
just for men. The total number of jobs has increased, due to women entering the
labor force en masse, and the population increasing. Still:

1) The total labor force participation rate, which
considers all of this, has declined in the last 15 years from about 67%, where
it was throughout the 1990's, to about 64% (from the Current Population Survey).

2) You bring up horses to some economists, and
other smart people, and sometimes the reply is, humans are different; humans
are just so much more flexible and adaptable and creative than horses, as in
the Dietz Vollrath quote at the start of this post.

The machines eventually got horses. They shifted
the demand curve inward so much that the supply had to decrease by over 99% to
keep the market wage for those horses that remained above the subsistence level.
And you could have made the same argument for horses that you hear all the time
for humans – It never happens. Hundreds of years technology has advanced, and
we've always found jobs for as big, or bigger, a population of horses.

Well, you know what, after hundreds of years of
technological advance, it finally did happen. Machines reached the point where
they were so good at almost everything you could employ a horse at that there
was no way for 99+% of the horses to do anything else that would pay even a
subsistence market wage.

So, relatively low-skilled, low-educated males are
not the entire group of humans. But, they are a class of humans, and a big one.
And what these data show is that it's not just a theoretical debatable thing about
the future. It's already very largely happened. They've already very largely
gone the way of the horse in the face of advancing machines (and I'll discuss alternative explanations).

Now, you could say, well, they could become more
skilled humans, and not go the way of the horse. But, the bar keeps rising, and
pretty fast, as these machines get smarter and smarter. Already that bar is
pretty high, practically speaking, for a substantial percentage of our
population to clear, and it keeps going up.

And, we have to then invest more and more in educating
our population, and crucially, Heckman-style early
human development (all of which will, very importantly, also greatly
increase the total size of the pie, of GDP long run). But the more we vote Republican, the less
we do this, as this money is instead shoveled into more yachts and mansions for
the rich. And, no, raising taxes on the rich will not have a substantial effect on the hours they work; this is wellshown empirically, and there is the long established in economics income and substitution effects and backward bending labor supply curve taught at every major university.

Cutting someone's after-tax wage from $10,000/hour to $5,000/hour still leaves plenty of incentive, and at these levels it's pretty much about attaining the prestige and feel of how your income and position and belongings and consumption rank, which is unchanged if your fellow rich pay the same higher tax rate. Your 10,000 square-foot house becomes just as prestigious and rare and awesome feeling and satisfying as a 20,000 square-foot one used to be before the tax increase.

But the main point I want to make here is that
robot/AI revolution causing unemployment to soar and wages to plummet, for a
large and growing percentage of the population, is not just some debate about
the future; the evidence is it's already well on its way.

Now, of course, what are other explanations for
the shocking collapse of employment and wages for lower-skilled males over the
last half century. There are two big ones as far as I know, globalization, and
the collapse of unions/bargaining power. Could these two be the predominant, or
overwhelming, cause of this plunge in wages and employment? and, males without a
college degree (from a well-respected university) could just shrug off the
effects of technology over the last 50 years – and over the next 50 years – and adapt with their superior, highly
flexible, human brains?

So all we’d have to do is legally well-protect
unions, and put up strong barriers to globalization, and employment and wages
and job security would be at least restored to the level of a generation or two
ago for lower-skilled males? And for everyone else.

Advancing robotics, AI computers, and other
machines wouldn’t have been, and won’t be, a major, or catastrophic, problem for
males without a college degree.

Is that it?

Well, let’s examine these explanations.

Unions provide much greater bargaining power for
lower-skilled workers, and so certainly raise wages greatly for those who have
jobs at companies with strong unions. This has been extraordinarily true in the
past, when many unionized workers without even a high-school diploma had
better wages and benefits than many high-skilled workers. Wages and benefits
that would stun the typical fast-food worker of today, or low-skilled member of
the
sharing economy (or is it the sharecropping economy?)

But that would be an explanation for the plunge in
compensation. It wouldn’t explain the plunge in employment, in the labor force
participation of lower-skilled males. If unions had remained just as strong,
and had kept on negotiating the same dream-like compensation for low-skilled
workers (dream-like to a Walmart worker today), if anything, this would have resulted
in even less employment.

Now, you might think that with strong unions,
employment for low-skilled males would be greater, as the unions would just
force it. They would strike and negotiate against automation. But this admits
that advancing machines are the cause. It just says that unions could stop, or
slow, this cause.

Next, what about globalization. So the idea here
is that trade barriers fell substantially, and the costs of transportation and
communication absolutelyplummeted,
and this led to low-skilled workers in the U.S. having to compete far more with
the vast numbers of low-skilled workers in the developing world. So essentially,
the supply of available low-skilled workers increased dramatically. And this
increase did not come with anything close to a proportionate increase in the
supply of available high-skilled workers to need the additional low-skilled
workers.

Certainly, this would depress wages and employment
opportunities paying at least minimum wage for low-skilled American males. MIT
Economist David Autor put it succinctly in a 2012
MIT News article on a paper of his on U.S. manufacturing job losses, “Trade
may raise GDP, but it does make some people worse off.” Still, University of
Oregon economist, and purveyor of the central economics blog, Economist’s View,
Mark Thoma, recently
wrote, “The evidence suggests that immigration and offshoring aren't the
biggest source of the problems workers face. Technological change, particularly
digital technology, appears to be a much bigger factor.”

I agree with Professor Thoma on this, based on the
research and information I’ve studied. But even if globalization were the
bulk of the reason for the collapse in wages and employment for low-skilled
males over the last fifty years, this would still
mean that advanced robots, computers, and other machines would likely devastate
low-skilled male wages and employment in the not too far future anyway. It
would still, nonetheless, happen, even
if all of the globalization were ended tomorrow.

Why?

Here's the logic:

First, even though I don’t think globalization is
the biggest factor, I have no doubt that the effect of it is very substantial
on wages and employment of low-skilled males.

But what are the products and jobs in question?

For this phenomena, it’s predominantly manufactured
and processed goods that can be transported in the ubiquitous uniform metal
containers; on ships, trains, and trucks.

So, the foreign workers that are putting supply
pressure on low-skilled American males are workers in production and processing
facilities and environments, because that's where the bulk of goods that can be
shipped in uniform containers are made, and that's where the bulk of the labor
hours to make them comes from.

And workers in such factories and facilities are one
of the kinds of workers that advanced robots and machines are best suited to
emulate. The work is relatively simple and repetitive, and
in a relatively standardized predictable environment.

So, the key point is that if foreign workers in
these kinds of relatively standardized, simple, and predictable environments,
with these kinds of also relatively standardized, simple, and predictable
tasks, are able to so devastate employment and wages for lower-skilled American
males over the last half-century, then machines would have done it anyway. Because
advanced machines largely can do the same things already, and it looks like there’s a substantial probability they
will be able to do the vast majority of this kind of work within the next
generation or two.

So, in other words, if this is your explanation,
then it would have happened anyway, or likely will happen anyway, from the
advanced robots and machines doing the same thing as the low-skilled foreign workers.

If low-wage workers in China and India can so devastate wages and employment for low-skilled American males, then so can low-wage workers in Robotia and Machinia and The AI Republic.

So again we see that advanced robots and machines can devastate low-skilled male
workers. But what is the evidence that machines will have
this kind of capability to predominantly do what foreign low-skilled
manual workers do?

Again, it’s largely in the books The Second
Machine Age, Rise of the Robots, and The Master Algorithm; and, the large 2013 study by Oxford’s Benedict and Frey, which is based on the opinions and
predictions of Oxford scientists and engineers. The authors conclude (page 45):

Our model predicts a
truncation in the current trend towards labour market polarisation, with
computerisation [instead] being principally confined to low-skill and low-wage
occupations. Our findings thus imply that as technology races ahead, low-skill
workers will [hopefully] reallocate to tasks that are non-susceptible to
computerisation – i.e., tasks requiring creative and social intelligence. For
workers to win the race, however, they will have to acquire creative and social skills. [emphasis mine]

And here is MIT economist Erik Brynjolfsson and
MIT computer scientist Andrew McAfee in The Second Machine Age:

After visiting Rethink
and seeing Baxter [a prototype, highly flexible, intelligent, and inexpensive
robot] in action, we understood why Texas Instruments Vice President Remi
El-Quazzane said in early 2012, “We have a firm belief that the robotics market
is on the cusp of exploding.” There’s a lot of evidence to support his view.
The volume and variety of robots in use at companies is expanding rapidly, and
innovators and entrepreneurs have recently made deep inroads against Moravec’s paradox.
(page 31)

And powerfully:

All these examples
illustrate the first element of our three-part explanation of why we're now in
the second machine age: steady exponential improvement has brought us into the
second half of the chess board [1] –
into a time when what's come before is no longer a particularly reliable guide
to what will happen next. The accumulated doubling of Moore's Law [2],
and the ample doubling still to come, gives us a world where supercomputer
power becomes available to toys in just a few years, where ever cheaper sensors
enable inexpensive solutions to previously intractable problems…

Sometimes a difference
in degree (in other words, more of the same) becomes a difference in kind (in
other words different than anything else). The story of the second half of the
chess board alerts us that we should be aware that enough exponential progress
can take us astonishing places. Multiple recent examples convince us that we're
already there. (pages 55-6, endnotes mine)

Other explanations for the collapse of wages and
employment for lower-skilled American males, like an increased desire or ability to claim
disability, or take on the role of homemaker, with a working wife, appear not
to be large factors, as discussed in Greenstone
and Looney’s article.

People today typically debate the future with regard to robot/AI revolution, will it be much harder to get and hold a job that can support a
family decently, or even pay minimum wage. Will
it take much more education to achieve this? Will this happen in some hypothetical advanced robot and AI computer
future?

Well, for male humans, it’s not a will. It’s a has. It has, to a very
large extent. The evidence I’ve presented I think is very strong on this. And
it hasn’t happened to just mere horses this time. Lower-skilled male humans are
humans, and they’re vastly beyond horses. And already the robots, AI computers,
and machines have brought them a long way toward the fate of the horses. And
these brilliant machines are just getting started.

You want to ask some will’s, then how about these:

Will it
take a bachelor's degree to have at least a 50% chance of having a reasonably secure career that can pay wages high
enough to support a family decently? And I emphasize secure, because I mean not
just can you usually hold a decent job, but will you be marketable enough that
you can avoid constant serious risk of long term unemployment before you find another
decent job. Because this risk is incredibly costly. Even one or two episodes of
3 – 12+ months of unemployment can devastate a family. Or can lead to homelessness,
which
is so harmful and dangerous, there's a very good chance it's game over from
there.

Will it
take not just a bachelor's degree, but a bachelor's degree from a
well-respected nationally-recognized research university, like my employer, the
University of Arizona? and those kinds of skills? Or even moreso, the literacy, numeracy, and technical skills of
only thetop half of graduates from respected national universities today?

Because if you say: Oh, ok, it's just horses and
men who don't make the effort to become skilled and educated enough, so no
problem, they just get skilled and educated enough, and then the robots and
AI's are no risk. Then, what if skilled and educated enough so all this is no
problem goes from high school diploma to bachelor's at a nationally known
respected research university, and with the commensurate skills? Or even the
commensurate skills of just the top half of such graduates today, so we can't
just grade hyper-inflate our way out of this, and throw up a bunch of Potemkin
colleges.

How are we supposed to get the vast majority of
men, and women, up to this level of skill and education?

To do so would take a regime shift in our politics,
and in public understanding of economics. By and large, one of our two major
parties not only does not believe in global warming, or evolution for that
matter, they don't believe in externalities, asymmetric information, natural
monopoly, contracting limitations and costs, and basically anything that says
the pure free market is imperfect (except in cases where it benefits the rich).
But providing a massive increase in the education, skills, and general
capabilities for most of the population is something that free market companies
could only extract a small fraction of the benefits from in profits. And
therefore they alone would grossly underprovide this.

The externalities, contracting and enforcement
problems and costs, adverse selection and other asymmetric information, and so
on, are profound and enormous. This is why general education has historically
been predominantly publicly funded. To say that now, so that most of the
population won't go the way of horses, we have to enormously increase our investment
in Heckman-style early human development, education, public nutrition,
healthcare, and more, from prenatal until at least well into a person's 20's, is to say that we should have an unprecedented increase in governments' size
and roles.

Right now, this is impossible, as the Republican
party is dogmatically against any government, except for a small number of
areas; mainly military, police, courts, prisons, and perhaps minimal public
infrastructure and education.

Of course, to win elections they have to favor
Social Security and Medicare for seniors. But, from my study of politics, I
think that most of those who control the party would like, if they could get
away with it without losing political capital, to end Social Security and
Medicare. And, in fact, they fought Social Security and Medicare toothand
nail when they were first enacted. And I also think that many of those in
control of the Republican party would like, if they could get away with it at
no cost in political capital, to eliminate most, if not all, publicly financed education, infrastructure, and research.

This is my conjecture, but certainly it's obvious,
and not controversial among experts, to say they would oppose any significant
increase in investment in education and human development, let alone an
increase to an unprecedented level. Just read their platform, and the positions
of their major candidates; it's pretty obvious that the direction they'd like
to go in is the opposite one.

So, if it's going to require a massive increase in
human development, education, skills, and general capability for most men not
to go the way of the horse, then that edification is not going to happen
anytime soon. And things could get very bad. And for a large segment of the
population, the statistics show it already has.

Republican control of the House (with gerrymandering,
disproportionate weighting of rural votes, etc.), and the Supreme Court, could easily
last another decade. And if the Republicans take the Presidency too, things could
go viciously in the wrong direction. They would likely be able to enact extreme
legislation and executive orders. Moreover, the Supreme Court, which could
strike down any major program, in spite of what's in the Constitution, could be
cemented in Republican control for another generation with a Republican
President to appoint more Republican Justices.

So, I don't think we can take that much solace in
the reply, all the low-skilled men have to do is become high-skilled to avoid
going the way of the horse.

Nonetheless, longer run at least, I do think that
this is a critical part of the solution (see, for example, my 2014 guest
post at Carola Binder's.) I do think that if we had a massive increase in
public investment in human development, especially Heckman-style early human development (Nobel Prize winning economist James Heckman's research has shown a high social return to public investment in high quality prenatal and postnatal care, training, and assistance, high quality developmental daycare and preschool, and other early assistance and intervention) that we would greatly decrease the percentage of our population without secure
employment. And we would greatly increase the size of the economic pie long-run.

Moreover, an unprecedented increase in human development investment would, in of itself, create an enormous number of jobs.

But the benefits would extend way beyond jobs. A
much smarter, healthier, stronger, less criminal, more knowledgeable and expert
population would make for a much stronger and better country, and a much
healthier democracy.

Eventually, there is a good chance that AI will
reach the point where few if any humans will be smart and skilled enough to do
anything pecuniary that a machine can't. At that point, substantial redistribution
will be unavoidable. Most people have little wealth outside of their labor endowment. If that becomes worthless, they quickly starve without
redistribution [3]. If we can maintain a
democracy, in spite of the efforts of many plutocrats, then large-scale
redistribution will probably be inevitable.

But, of course, there will be an aversion to just
giving people money without it being earned. But there, a solution I see is
allowing people to earn it by working to become better people, and citizens.
The redistribution can be money paid for the job of being a student; getting a
college degree, a graduate degree, passing expertise exams,... Or, money paid for
hours spent on a physical fitness program, or studying chess and improving
your intellect and game, or Tai Chi, Yoga, psychological study, or therapy...,
at least until you have reached a certain number of hours worked, or age, and
are allowed to retire with a pension if you wish [4].

So, in this way, there may be one job that we can
never lose. In the end, our final job may be ourselves.

[1]
This refers to an old story that the inventor of chess presented his game to
the emperor of India, who was so impressed, he asked the man what he'd like as
a gift in return. The man replied, simply some rice for my family, one grain on
the first square of the chess board, then two on the second, four on the third,
and so on, doubling until the end of the board. The emperor agreed, thinking it
a modest request. But due to the power of exponential growth, the last square
would require 263 grains, more than 18 quintillion; more rice than
has been produced in the history of the world!

In the first half of the chess board, the number of
grains grows relatively, or very, slowly. For a while the growth looks linear,
and with a modest slope. By the end of the first half of the chessboard, the
current square is about 4 billion grains, still just one large field. But now
we're in the famed "second half of the chess board". Each doubling,
or square, now causes not a small improvement, not a relatively modest, or
ordinary, improvement, but a qualitative leap.

And the idea with computer advance, and Moore's law, is
that we are at, or near, the second half of the chess board, where every routine
doubling of Moore's Law, or similar doubling in computer-power-per-dollar-of-cost, due
to software advance, 3-D circuits, parallel processing, etc., causes a startling
increase in capability. An increase equal to every increase that came before it for the last 80 years. For supercomputers this means that a new square on the
chess board, which happens every few years, now
means an additional
thirty-four thousand million operations performed everysecond! Very
different than early doublings, which only added hundreds of calculations per second to the capability!

[2]
Many experts expect Moore's Law to continue for decades or more, at least in
spirit. Originally, Moore’s Law, or “Law”, as it’s an observed and predicted, approximate relationship, not an immutable physical law, was basically that the
number of transistors per square inch would increase exponentially for a long
period. But the term, “Moore’s Law”, is often used now to say, basically, that
computing power, or capability, per dollar of cost will increase exponentially over a
long period. And I think this is a much more useful definition. The number of transistors per square inch cannot double
that many more times before a transistor becomes as small as an atom. So
we're approaching the physical limit of matter's smallest units, and many
experts say the practical limit will be hit in a decade or less. But there are
many ways that the computing power, or ability, per dollar might keep doubling
every few years for decades or more.

These include: (1) 3-D chips
– micro-layers of chips on top of each other; (2) Directed
self-assembly (DSA); fascinatingly, this is like the way DNA constructs our
bodies. Certain molecules attract or repel others, and you use this to form the
transistors, the connections between them, and other components and
architecture in a chip. This can both plummet the cost of production, and create revolutionary
increases in capability; (3) Improvements in architecture in general; (4) Massively Parallel Processing, like the human brain. This can lead to an astounding
increase in capability, but it also can plummet power usage and heat. The human brain,
which is incredibly massively parallel, has in many ways the capability of
today's supercomputers, and more, but with about one one-billionth the energy
usage; (5) Quantum Computers; (6) Advanced new materials like carbonnanotubes,
potentially inexpensive room-temperaturesuperconductors, and other new nanomaterials with amazing properties and applications; (7) Much faster and denser memory, such as RRAM (Restrictive Random Access Memory);(8) And there is more; this is not an
exhaustive list.

And one thing I'd like to especially focus on is
software advance. We always hear about hardware speed and capability doubling,
but often as important, or even more, is the exponential advance of software.
There are many examples you can give – Machine
learning, which is revolutionary, is the reason for computers driving
cars in dense city traffic, recognizing faces better than humans, and beating
the best at Jeopardy. It is a new kind of software (at least in this form, and at
this level). Certainly, it is made more powerful with hardware advance, but
that hardware would never have been capable of coming close to what it does
without this software advance.

MIT's Brynjolffsen and McAfee wrote in their
first book on robot/AI revolution, Race Against the Machine (2011),
"It also seems that software progresses at least as fast as hardware does,
at least in some domains. Computer scientist Martin Grotschel analyzed the
speed with which a standard optimization problem could be solved by computers
over the period 1988-2003. He documented a 43 millionfold
improvement...Processor speeds improved by a factor of 1,000, but these gains
were dwarfed by the algorithms, which got 43,000 times better..." (page
18).

So, as a result of all of this, we see many different promising
avenues by which "Moore's Law", at least a Moore's Law for doubling
of capability per real dollar of cost, can continue for possibly decades, or
more. And these doublings are now in the second half of the chessboard (see
endnote 1 above), where each one is a gigantic, and possibly profound, advance.

[3]
One might argue that with the technology explosion things would get so cheap
that even a small amount of savings, maybe even $1,000 or less, would be enough
to live ok for a lifetime. However, interestingly, I think this would be unlikely
to work. The real price of at least many goods will plummet, but remember, the Fed, and all first-world central
banks, hate even moderate deflation. For this to work, for your $1,000 to blow
up in real value, they would have to allow hyperdeflation. Extremely unlikely.
They are going to print as much as it takes to prevent more than at most modest
deflation.

For you to have your wealth explode in value will
require having it in real assets, like stocks, or ownership of raw materials that will be necessary, and relatively rare, in the robot-revolution future,
not cash or fixed-interest bonds. This looks to me like the way to hedge
against robot/AI unemployment, other than things like improving your and your
children's education and skills.

I'll eventually do a post on this, but for now, if
you'd like to find out more, please see my comments here, and this recent post.

Monday, August 31, 2015

Let's consider real estate. A very serious bad future state [1], with a very substantial probability for most people, is artificial intelligence/robot revolution decimating jobs and wages [2]. What will happen to real estate in that state? The 80%+ have had their employment, and employment security, decimated, and wages have plummeted. How is that going to affect their ability to bid on homes and apartments?

And simultaneously, these robots will be able to build new homes and apartments at a fraction of the cost it takes today – Heard of massive 3-D printers on rails printing an entire track of homes' frames [3]? You will. When in the not too far future new homes, apartments, and offices can be built for half the cost, or a quarter of the cost, today, and be much higher quality, with incredible energy efficiency, solar built right into the structure, the walls even, and incredible computer control of the home or office built in seamlessly and beautifully, with amazing new materials for soundproofing, durability, and beauty, how is that going to affect the price of the real estate you're buying today?

So, real estate will plummet in this AI/robot revolution state, while in this same state the tech explosion may be very good for the owners of the robots – the owners of stocks. An asset that plummets in a majorly important bad state? Very risky. One which does well in that state, important insurance. The discount rate for the former is very high, all other things equal (and the former's expected return is also, I think, far lower than almost everybody thinks, because almost no one is considering this AI/robot revolution scenario with regard to real estate investing). The discount rate for the latter is very low, all other things equal.

Yes, there's also the possibility of the winner-take-all explosion getting the bulk of the tech revolution's bounty, but still, the 80% won't be winner-take-all's (WTA's), so at least they can own still needed robots, and raw materials, and patents, and have some negotiating power with the WTA's through the corporations they own, so they get some substantial percentage of the bounty; the WTA's don't get it all.

Because of the great future technological danger to the 80%+, stocks are becoming more and more insurance-like long run, and so meriting a lower and lower discount rate (even though very few people will think about this). And at the same time, bonds are currently paying nothing, and real estate is looking very risky long run.

So, what is better than stocks for long run savings? I ask seriously.

And, especially since Shiller wants to use historical comparisons for P-E ratio, we should also consider historical comparisons for other things too. Shiller writes, "… and within a year or two restore CAPE ratios to historical averages. This would put the S&P closer to 1,300 from around 1,900 on Wednesday."

Ok, so if we're invested in the S&P 500 now (a broader market index is better, like the Vanguard Total Stock Market Index Fund, or one of the many similar offerings available elsewhere) at 1,900, and it drops to 1,300 in 1.5 years, how long until it's back up to 1,900 (adjusting for inflation too, so in today dollars)?

Well, we're going with historical averages, like Shiller, right? So what's the historical average real return on the stock market? Wharton's Jeremey Siegel has possibly the best long run data base. In his seminal book Stocks for the Long Run, 5th edition, he finds that from 1802 until 2012, the geometric average return was 6.6% real, inflation adjusted. And it was about the same for three major sub-periods in this 210 year span (see chapter 5).

So, at 6.6%, how long until the 1,300 gets back to 1,900? Taking out my trusty Hewlett Packard 10bII, 5.93 years. So, in about 7.5 years we're back where we started, inflation adjusted. And that's better than government bonds, which have a somewhat negative real expected return, and about equal to high grade corporates which are at about the expected inflation rate.

But what about after 20 years pass? We keep up with that historical 6.6% average, and after 20 years, 12.5 years will pass since break-even. Those 12.5 years take us to 4,361. So, investing today, with these historical averages, 1,900 goes to 4,224 in 20 years. That gives us a 4.08% real return.

What's going to beat that today? And with a risk level that provides insurance against future inflation (stocks are ownership of real assets which go up with inflation) [4], and crucially, robot/AI revolution causing devastation to employment income and security for the 80%+.

Even if Shiller's right with his historical averages, what's going to beat stocks for long run investment? And yes, if you knew stocks would drop to 1,300 first, then you'd leave until it happened, and then go back. But that's risky to try. It's far from certain they will drop to 1,300. What if things start going really well in the economy? What if the robot/AI revolution starts to really take off within just the next few years? P-E's could start dropping fast not because prices drop fast, but because earnings rise fast.

I still can't see a better vehicle for long run savings than a well-diversified stock portfolio. If you know of one please let me know.

A final point: It is possible that investors are a lot more savvy than in the past, and so less unduly afraid of the risk of stocks. Therefore, they discount their future expected earnings less, resulting in a new era of higher P-E ratios.

So this would argue for stocks not being overpriced at their current CAPE's. INSEAD economist Antonio Fatas just made this point:

The other justification for high CAPE ratios is that the risk aversion of investors has gone down relative to previous decades. While talking about low risk perception this week might not sound right, the reality is that the years while the stock market had CAPE ratios of around 17 where also the years where academics wondered about why risk aversion was so high among investors (what we called the equity risk premium).

So, here we get to the famous equity premium puzzle in financial economics. I've talked about this a lot in previous posts because for years I've had an explanation that I haven't seen in the literature, and I've studied this literature very thoroughly as a finance PhD student, you can't help but. So, please bear with me, and let's talk about this; I really think there are important points to think about.

The equity premium puzzle is that going back a century or two in the US (and this has also been observed in almost every developed market) stocks appear to have had a very high real return relative to their risk. So the question, or "puzzle", is how can this have persisted for as long as two centuries. With people being oh so efficient, oh so smart, expert, and savvy; or, with the expert minority being willing and able to buy as much of assets as it takes to push them to efficient pricing, or so they say, why wasn't the return on stocks bidded down?

Or at least, why have most people put so relatively little of their savings into stocks when the expected return relative to the risk seems so good?

And the explanations that have gotten published in the top journals basically come down to maybe for some reason stocks are riskier than they appear to be, and the general public understands this better than finance professors with massive statistical, mathematical, theoretical, and empirical knowledge. Or, people are a lot more risk averse than they appear to be.

So there's this thought that if people discovered what a good deal stocks are, they would start investing in them a lot more, and that increased demand would push up the price of stocks, and thus down their expected return from that point on.

So, it's always a thought about demand. Once people wake up and see that stocks aren't that dangerous for getting so much higher a return on average, then they will start bidding down the expected returns permanently, until they are no longer such an abnormally good deal.

But, what I ask is if this were any other good, would we think that once consumers change their attitudes and greatly increase their demand, the price of the good must go up, not just over the short run, but over the long run too?

And the answer, from long established and well proven economics, is not necessarily at all.

It comes down to the production technology, the supply side. Is it constant returns to scale, the old CRTS, or increasing returns to scale, IRTS, or decreasing returns to scale DRTS, or is the supply fixed, perhaps like gold (although, while the supply of gold on the planet is fixed, the supply available to the market is much less fixed; it depends on surveying and mining technology).

And whether production is CRTS or IRTS or DRTS can depend on the quantity and time horizon. For a large range of quantities production may be IRTS, then it may go to CRTS after that, and finally if you keep producing more it will eventually go to DRTS.

Well, with stocks, what are you purchasing? Ultimately, the money put into stocks goes into corporate investment projects. And those investment projects ultimately produce goods. Now, what I argue in my explanation of the equity premium puzzle is that investment projects financed with equity, rather than debt, are intrinsically more productive. It's like a technology that produces more output. If you produce with technology X, for every $100 you invest in that kind of production you will permanently get $3/year of goods out. But if you invested that $100 instead with the more efficient technology Y, then you would produce more, $7/year.

And why might equity-financed investments be more efficient and higher productivity than debt-financed? Because equity financing gives managers the option much more to take much longer term projects whose exact fruition and cash flow is harder to predict with certainty, but have nonetheless a very high risk-adjusted expected return. If the financing is in debt, often these projects will be forgone, because the debt provides an often very substantial risk to managers from taking on these projects. If the cash flows don't come in in time, the company can be put under severe financial distress, really costing the manager who took on that project in his career, in just keeping his job. Equity is flexible, there are no fixed interest payments which must be made on precise schedule to avoid very bad consequences. So, basically we can expect, given this, that equity-financing will persistently provide a higher risk-adjusted return than debt.

Now, what if suddenly people recognize this much more, and start investing much more in equity to take advantage of this, say twice as much. Will they bid down the risk-adjusted expected returns on equity? Well, not if there exist twice as many good equity projects. So, in other words, if the good equity type projects are CRTS over this range, then the increase in demand won't move the price. The long run supply curve is flat over this range, and so an increase in demand does not change the price. In fact, if the potential equity based projects are IRTS an increase in their demand would even push up the risk-adjusted expected return, allowing for excellent large scale projects that otherwise wouldn't have been possible.

So, this is my supply side explanation for the equity premium puzzle. For more, I have a brief write up here. And so when Fatas writes, "But I wished that he [Shiller] would have considered as well the third possible scenario where current CAPE levels are fine and investors should get used to lower-than-historical returns but returns that are consistent with what is going on in other asset classes.", he's saying that maybe now investors are more savvy, and so are willing to invest a lot more in stocks and so will push down the risk-adjusted expected return, but be fine with that. What I'd reply is that even if what he hypothesizes about the demand side is true, it will not necessarily mean lower future risk-adjusted expected returns for stocks due to my supply side explanation, where higher demand will just mean more of these high risk-adjusted expected return equity-type projects get financed. And less will be financed through less efficient debt. Which may be a very good thing.

[1] The state of nature framework is standard in academic financial economics. You say in the future there are a number of possible states, where various things happen, or various levels of good or bad economic factors occur. And each state has a certain probability of occurring.

[2] To learn about this I recommend, The Second Machine Age (2014), by MIT Economist Erik Brynjolfsson and MIT information technology expert Andrew McAfee, and Rise of the Robots (2015), by software expert and entrepreneur Martin Ford. Ford's not an economist, and the economics is often off, or quite wrong, but the technological information is amazing, and often surprising.

[3] See Rise of the Robots above in endnote 2

[4] I'm not talking about Zimbabwe inflation, but over the next decade or two it is possible we'll start intelligently considering the dangers of lowflation, the ZLB, and lost decades, and raise the target to 3 or 4 percent, even 5, or at least make the current 2% a target, not a ceiling.

Sunday, July 19, 2015

It's because here I think I've really nailed it,
really gotten at the heart of it, in a way that's relatively quickly accessible to professional economists (and maybe
to well-educated laypeople too, but probably only with a great deal of side
googling and reading). So, I think this one really stands out from the others,
and is the one that I'd like to make my, "the explanation", or at
least my relatively concise and accessible explanation.

It's not that I
think my earlier attempts were wrong (by and large). It's just that there are
many valuable intuitions you can get from Wallace '81, but what I'm about to
present to you, I think, really gets at the heart of it, and thoroughly, from
the start of the process through to the finish.

Now, as you can
quickly see, this is very long for a blog post. But I think it's well worth the
time to be one of the very rare people to really understand (and not
misunderstand) this crucial model in the quantitative easing, and just whole monetary
policy, debate. However, I will next, in a future post, try to condense this a
lot, and perhaps make it more accessible for well-educated laypeople.

But really, for
economists and other professionals, this is not that long at all to be one of
the few people in the world to really understand this intuitively. And the
depth it contains is really worthwhile for professionals. It may sound egotistical
for me to say that, but I honestly think it’s true, and important to make clear.
It's still short for an academic work (with some blogging humor, informality,
and commentary), and I think it's well worth the relatively short time.

O.k., so let's
get to it:

Suppose the
government decides to do a quantitative easing (QE) where it creates, and sells,
one more dollar ("unit of money"). In the Wallace model, it sells
dollars for the single composite consumption good, which I have nicknamed C's.

C's are the
real deal, real goods, what everyone ultimately wants, and the one and only
argument in their utility functions. And, C's are what people sell their
financial assets for, when they eventually sell them.

So, that dollar
is sold to, let's just say in this first scenario, one person, even though
everything is infinitely divisible in this model.

What's the cost,
the price in C's, of that dollar?

Well, first,
we're trying to see if this QE can be done without changing the price of any
asset in the economy at all, whether financial or real. And that includes
money, so with no inflation. And this is what Wallace claims in his Irrelevance
Proposition.

Thus, we're
going to assume that all prices remain unchanged; they are as before. And then
we will see if equilibrium still holds after the QE if we still have those
original prices.

The previous
regime we call the "_" regime. So, the previous state prices at time
t were s_(t). The previous money supply in circulation was M_(t), and so on.
And the previous price of a unit of money in C's was p_(t), all consistent with
Wallace's notation.

So, if p_(t) is
4, then it takes 4 C's to buy one dollar. If all you have is 1 C, then you can
only buy a quarter.

Now, we started
in equilibrium in the "_" regime. This means, by the rules of this
model, and almost all modern macroeconomic models, that all people were
perfectly optimizing at the current, and forecasted, prices. All people had,
with their perfect, super-human, foresight, knowledge, expertise, and calculating
ability, figured out the 100% maximum utility consumption plan for now and the
rest of their lives. And they we're going to follow it perfectly, with their
perfect self-discipline; saving and investing exactly as necessary to
accomplish it.

And also,
markets are assumed to be complete (which is actually crucial), and
frictionless, in Wallace’s model.

So, any given
person h, of generation t, had a consumption path over his two period life, ch(t),
that perfectly optimized his utility, given his budget constraint, and given
the ability to buy and sell anything perfectly and frictionlessly in the complete
markets with state prices s_(t) .

So, as I
started to say, before I was so rudely interrupted, by myself, suppose the
government decides to do a QE where it creates and sells one more dollar.

Some person,
we'll call him person z, decides to buy that dollar for p_(t) C's. And, the
government decides to, in turn, promise to buy it back from him next period for
the perfectly foreseen, at least given the state, market price of p_(t+1).

I'll later get
to why we assume the government will promise to do this, and will honor its
promise with 100% certainty.

Remember, in
standard macroeconomic models today, including Wallace '81, everyone has
perfect foresight about, basically everything, including the state-dependent
future path of all prices. They don't know what state will occur, but they do
know what any price will be perfectly given a state, or path of states, occurring.

And, the government
promises more:

When they sell that
dollar they will store/invest the C's they get for it, earning a
state-dependent return of x(t+1). The state-dependent return vector for storing
C’s at time t is specified in the Wallace model. It’s considered exogenous, and
very interestingly, and consequentially I think, it does not depend on
quantity.

The demand to
put your C’s into this x investment, no matter how big it gets, never pushes
down the return. It is essentially like continuous-returns-to-scale technology.
You never run out of x type investments or projects. Their supply curve is
perfectly flat, at least for quantities as high as could ever occur in the
world of the model.

The important
results of the model depend on this. And I really found it interesting because
for years I’ve had an explanation of the equity premium puzzle that was based
on this kind of supply.

So, please bear
with my digression here:

Basically, my
idea is that equity gives managers a lot more flexibility in how they invest
funds, especially long-term, compared to much more constrained and difficult
debt. As a result, the firm can invest the funds more efficiently and productively
over the long run with this increased flexibility. Therefore, they can put the
funds in higher, even risk-adjusted, return projects than they can with
debt-raised funds – There’s no worry about potential disaster from having to make
short run interest payments so you decide to pass up better much higher expected
return, but longer run and somewhat more risky projects, that, again, to be
very clear, are higher expected return even
when adjusting for their increased risk.

If the supply
curve of these good, equity-based, flexible long-term projects in the world is
very long and flat, at about the historical high average equity return
(approximately 7% real), then even if the demand for equity did get really
high, because it’s such a good deal, with such a long flat supply curve of
projects at a rate of 7%, the equilibrium rate still won’t get pushed down
below 7%.

Essentially,
with this explanation there’s always going to be a really big equity premium,
not because of something puzzling about people’s utility functions, or
behavioral factors, or there's some hidden source of risk we're not seeing, but
just because you will always be able
to find equity projects that have a much higher return than the average debt
project – as many as you need. Equity just increases the efficiency and
productivity greatly by not having all of the hassles and constraints that come
with debt, and the result is projects that produce a lot more, especially over
the long run, even when considering any increased real risk (although the
question still remains, why don't investors jump on this more; why is there not
more stock in their portfolios).

You hear a
concern with the equity premium puzzle that once people realize that the
risk-adjusted return on equity is so high, the demand for equity will shoot up,
and its expected return will come down. But this will not be the case if
equity-based projects just have a very real and very substantial flexibility
and efficiency advantage. And the number of such possible projects is easily
high enough to meet even a great increase in demand.

Of course, this
is an explanation for why the risk-adjusted equity premium is so seemingly
high. There's still the "puzzle" of why people then don't jump on
this much more. Why then do they invest so relatively little in stocks,
because, after all, we know the market is sooooooo efficient, and people are
soooooo rational, and knowledgeable, and expert – in
everything, in an ultra-complicated world that's light-years
from 1810. Otherwise, libertarianism might look a lot worse, and a government
role a lot better. Horrors!

But might I
just offer a crazy idea. Perhaps the "puzzle" of why people seem to
underinvest in stocks when they appear to carry such an abnormally high
risk-adjusted return is not because they know some hidden sophisticated kind of
risk that finance professors don't and are missing. Perhaps, just perhaps,
instead, it's because 65% of people answered
incorrectly when asked how many reindeer would remain if Santa had to lay
off 25% of his eight reindeer.

Anyway, I’ve
never seen my supply-side explanation of the equity premium puzzle in the
literature, and I’ve studied this a lot. As a finance PhD student, you can’t
help but. And I don’t know why. It seems to make a lot of sense. But assuming
there’s not something wrong with it that I don’t see, it’s likely going to take
someone with a name, and/or at a name, writing it very formally, full of math,
and completely, to get it considered.

Anywho,

Ok, end of
digression, back to Wallace's model.

Recapping where
we left off in our QE:

1) The
government prints one more dollar. It sells it to a person for the price of
p_(t) C's.

And p_(t) is
part of the previous regime of prices, the "_" regime, which had us
in equilibrium before the QE.

2) The
government takes the p_(t) C's it gets and stores/invests them for the
state-dependent return it will get next period, x(t+1).

3) Next period
– time t+1 – the government will buy back that extra dollar that it printed in
its QE.

So, that's
where we left off. Now let's continue.

The government
sold a dollar for p_(t) C's. It stored/invested those C's for a return of
x(t+1) to get p_(t)x(t+1) C's at time t+1.

Then, also at
time t+1, the government will buy back that dollar it printed in the QE for
p_(t+1) (That will be the price, if the price path that we started with before
the QE stays the same afterwards. And we will see if equilibrium can still hold
if it does.)

All of this is
implied by the equations in the model, primarily requirement (b) of the Irrelevance
Proposition.

Therefore, the
government will make a profit/loss from the QE, at time t+1, of:

p_(t)x(t+1) –
p_(t+1)

What does the
government do with this profit or loss?

Equation (b)
requires that the government foist it on the people. The government gives it to
one or more members of the citizenry by adding it to their taxes net of
transfers. If it's a profit, hey, tax cut! and/or increase in transfer
payments! If it's a loss, tax increase, and/or decrease in transfer payments. But
due to the perfect foresight and public information that Wallace's model
assumes, the people know exactly how the government is going to do it
beforehand, and to which specific citizens. And they act accordingly in an
optimal way.

Now, WLOG
(without loss of generality; this will still be true in general, even though
now we will restrict our attention to a specific case.), for simple clarity,
let's, for now, assume the case where the government announces its plan to
foist this profit/loss on just one person,
our intrepid person z. They're not going to split it 50-50 between persons z
and w, or 71-29, or split it evenly among every person in the country. They
could, again WLOG, as I'll go into later, but here the whole profit loss that
will occur at time t+1 will go just to person z.

How will person
z, an optimizing mother–shut your mouth! (Shaft reference for you young'ns),
react to this?

Well, person z
was optimizing before the QE. The amount of saving he chose, and how he chose
to invest that saving, was optimal given the prices (and state dependent price
paths) at the time, the "_" ones.

If those prices
don't change, as we posit, but now person z finds out he will be getting, p_(t)x(t+1)
– p_(t+1), at time t+1, how will his optimal strategy change?

Will he save
more in his two period life? Will he invest his savings differently? Buy a
different set of state-price contracts, store/invest more for the return
x(t+1)? What?

Well, the first
thing to notice in answering this question is that the profit/loss, p_(t)x(t+1)
– p_(t+1), at the existing "_" state prices, is, at time t, worth,…

Zero

You're giving
person z, at time t, something that's worth zero at time t. Its net present
value at the current ("_") state prices is zero. It's not a cost, and
it's not a benefit.

Why?

We started in equilibrium,
so there were no arbitrages, and Wallace explicitly requires this with
equations (3) and (4).

If p_(t)x(t+1)
is worth more than p_(t+1) at the time t state-prices, then there would be an
arbitrage. You would just:

1) Sell short a
dollar to someone, and get p_(t) C's. You now owe them a dollar at time t+1,
which will cost you p_(t+1) C's at time t+1.

2) You take
your p_(t) C's and store/invest them at x(t+1) which will give you p_(t)x(t+1)
C's at time t+1. You use those C's to pay off the person you owe from the short
sale a dollar, which costs you p(t+1) C's to buy.

So, this
strategy cost you nothing at time t, and at time t+1 you get:

p_(t)x(t+1) –
p_(t+1)

If this
expression is not zero, then an arbitrage would exist. So, given you assume
that the economy starts in equilibrium, you assume that this expression is
equal to zero.

I'm not going
to show the details of every arbitrage in this post to keep it from really
getting long, but if you'd like to see them, just email me. And, I'll
eventually do an article version of this which will at least be at my academic
site, which will go through all claimed arbitrages in end notes or appendices.

So, the
profit/loss that the government foists upon person z (or some combination of
citizens in the economy) is worth zero at time t. So person z can completely
rid himself of it for free. He can sell it in the markets for nothing. And, in
fact, that's just what he will do!

How can I be so
sure of that? Well, whatever his utility function was, he was optimizing perfectly
before the QE at the market prices (and their state-dependent paths) that
existed before the QE. If those same state prices still exist after the QE (as
we're assuming, and then seeing what happens), then he will choose the same
consumption and investment path as before. He won't change anything. Give him
some new investment, worth zero, that changes his state-dependent consumption
and investment paths, and he will sell it.

A good way to
look at it is this: There are perfect complete frictionless markets, and perfect
people; a person has a lifetime path of income and transfers net of taxes. And
in optimizing it, what he essentially does is say, what's the net present value
of all of that at birth. People are supermen right out of the womb! Or time t.
Then, with that net present value lump of wealth, he plans out completely the
consumption and investments he's going to buy over the course of his life, to
perfectly optimize his expected utility function.

As long as the
net present value lump he's born with is worth the same amount, and as long as
the state dependent price paths are the same, he's going to have the same
possibility set to choose from. And he will thus will chose the same optimum
(Wallace restricts the possible utility functions hardly at all, but he does say
they're well behaved so that the optimum is unique.)

Foisting on a
citizen a profit/loss from a QE that has a net present value of zero at the
prices in a frictionless and complete market doesn’t change the possibility set
at all for that citizen. So he will optimally chose the same exact
consumption/investment path as before. And to get to that path he just sells
this QE profit/loss for zero. In other words, he will engage in transactions to
100% undo it.

Now, next
question: How exactly does he undo it, and who takes the other side of those
transactions if market prices stay the same as before the QE.

The answer is,
he does the opposite of what the government does in its QE transactions, and so
the government is taking the other side of the transactions.

Specifically:

When the
government sells that extra dollar in its QE, person z buys it from his private
storage of C's. Thus, his saving in stored C's goes down by p_(t) C's, and his
saving in stored dollars goes up by one dollar.

And, at time
t+1, when the government offers to buy back that dollar at the same price path
as before the QE, he buys it back.

What does all
of this get person z? How does this alter his wealth at time t+1?

The forgone
p_(t) stored C's used to buy the dollar at time t, means that he won't get a
return of x(t+1) on those C's now. So the loss is: –p_(t)x(t+1).

But, he will
now be able to sell a dollar for p(t+1) at time t+1.

So, at time
t+1, his wealth will go up/down by:

–p_(t)x(t+1) +
p_(t+1)

And the government
will be foisting the QE profit/loss on him of:

p_(t)x(t+1) –
p_(t+1)

So, the two perfectly cancel each other out, and
he's left with the same exact consumption/investment path possibility set as
before, and so he will do exactly the same thing as before. And because he will
voluntarily take the other side of the government's QE transactions at the old
market prices, the old market prices will have no pressure to move. They'll
stay the same.

So, boys and
girls, if you start in equilibrium with a certain set of market prices and
optimizing behavior of your citizens, you will stay in equilibrium after this
QE, and with no change in prices, of any asset, including money, and no change
in consumption and investment decisions of any person! Viola!

But! A lot of
things to note.

So, it works in the model. But,
important notes:

Wallace's
requirements for a QE are really strong and unrealistic. This is really
sensitive to and dependent on perfectly complete and frictionless markets,
which we are far from. Let alone perfect expertise, perfect public information,
perfect self-discipline, perfect liquidity, superhumans.

But still, even
given these things, you might ask in the just completed example, what if our
intrepid person z, who the QE profit is to be foisted on, doesn't have any
saved/stored C's with which to buy the government's newly printed QE dollar?

Well, complete
and frictionless markets! Person z borrows p_(t) C's from someone, and uses them
to buy the QE dollar.

At time t+1 person
z owes that person what that person would have gotten had he stored/invested those
C's as originally planned: p_(t)x(t+1).

But, person z
will get at time t+1, p_(t+1), from selling the dollar. So, the net at time t+1
is:

–p_(t)x(t+1) +
p_(t+1)

Just as before.
Which will neutralize completely the QE profit the government will foist upon
person z at time t+1.

O.k., so what
else could go wrong?

What if, in
foisting the government's QE profit/loss on the citizens, they decide they will
give it to person z only if it's a
profit, and person w only if it's a loss. That would certainly cause a change
in those two people's consumption and investment plans, which would then put
pressure on prices to change.

Well, uh-uh.
Wallace has that covered. He just doesn't allow it. Any QE, or other
monetary/fiscal operations, are required to not change the net present value of
any person's lifetime wealth. So, every person's consumption/investment path possibility
set must remain 100% unchanged by the QE. This is what requirement (a) of the
Irrelevance Proposition means.

Note, of
course, that in the real world any profit/loss the government has from a QE
will not be distributed so that there are no winners and losers. If the QE ends
up taking money away from the government, some people will lose, and others
won't be affected, or won't be affected as much. If the QE gives money to the
government, some people will get tax cuts/transfers; others won't, or will get
smaller tax cuts/transfers.

So really,
honestly, in this model it works because Wallace rigged the game, with his
extremely unrealistic requirements for the QE, and assumptions about the people
and markets. This is not to say that the model is still not good and useful,
that it still cannot give us intuition, but it does show the folly of interpreting
it literally to reality.

The Natural State in the World of
Wallace – Hold on to your seat!

Now, important
and interesting note: People voluntarily hold money in this model even though
no liquidity/convenience benefit is included. They do so for the financial
return. It's an interesting (or funny) thing about this model, and it makes it
so that deflation – and the zero lower bound – are the natural state!

Why? We're
assuming we start in equilibrium, so all assets are held unless they are
worthless. But a monetary model where money is always worthless is not very
useful, so Wallace mathematically requires that this cannot happen with
equation (4), which makes it so money is worth something: p(t) > 0, all t.
But the only way it can be worth something in this model is its financial
return, since the model gives it no convenience for making transactions benefit,
or ease of wealth storage benefit. The model gives it no benefits at all other
than its return, no different from any other financial asset.

And if you were
to calibrate this model to typical historical conditions in an advanced
economy, the expected return on all financial assets would be positive (other
than those which act as insurance). Thus, typically, money appreciates, i.e.
deflation! And people voluntarily hold money without getting interest, just for
the appreciation.

And in this
model there's not a reason to pay interest when borrowing money. First, if
someone borrows a dollar, there is no default risk. The model does not specify
one, and it includes no frictions. And dollars, unlike C's, are not productive.
They don't produce anything over time. It's C's, the real goods, that produce
something, and give you that return the model specifies of x(t). Papers with
dead presidents just sit in a vault, or as electrons on bank computers. You
only get a positive return from them if their price in real goods, C's,
appreciates, which it does under normal circumstances.

So people are
going to hold these papers with dead presidents collecting dust and doing
nothing anyway. It's no cost to them to loan them to someone during the time
they were going to just sit there anyway. And the markets are frictionless, so
there's no extra fee for selling short any asset, including dollars. You might
say the perfect competition in the model, no monopoly power, pushes the short
selling fee to the actual costs of the short-seller, which are zero.

But finally, in
the model, equation (4) makes it so the price appreciation alone makes the
return on dollars fair at the current state prices. If there were interest on
top, there would be an arbitrage. You would just construct a synthetic dollar,
like with state price contracts, sell it short, buy an actual dollar, and
collect the interest for free. So the arbitrage pressure will push the interest
rate on dollars to zero.

There is,
though, the question of why in the real world then money normally has a
positive interest rate. I would say the answer is that the interest rate is
really on the borrowing of real productive goods. The money just facilitates
the borrowing of real goods transactions.

But in any
case, you can see clearly by arbitrage that in Wallace's model money pays no
interest. All you get is appreciation.

Thus, the
interest rate on money is zero, i.e., zero lower bound!

So in Wallace
ZLB and deflation are not some weird exception; they're the rule!

Wallace Neutrality in the Real World?

Ok, now, we
see, hopefully, the intuition for why irrelevance works in the model, why a QE would have no effect, but what about in the
real world?

First, of
course, the vast majority of people in the real world are very far from having
perfect expertise in finance – and every other subject there is – as the
Wallace model, and the typical modern macro model, assumes. They're also far
from possessing in their brains all of the public information there is, and
being able to access it, and analyze it, instantly, perfectly, and costlessly,
to find the perfect optimization path for their consumption, and how to invest their
savings.

So, of course
we don't interpret this kind of modern macro model literally to the real world.
We think very carefully about how the big, or comically
big, deviations of the real world from the model's assumptions will affect
the results, how policy will work, and what the optimal policy is for what you
want, and for your values, for what your optimization function is for society,
for what your loss function is, etc.

This last one
is not a normative statement where I note one's values, loss functions, etc. I
am saying – to give an example – if
you want to maximize total societal utils, then
this is the best policy. I'm not saying you should choose the policy that
optimizes total societal utils, just like if I give the policy that's Pareto
optimal, I'm not saying that you should choose that option.

And no, you
don't do the Pareto option automatically. Just because it's better than the
status quo, does not mean it's the option society will prefer the most of any
available option. There
are other choices besides Pareto and the status quo. One of the biggest
ones of interest to most people would be the one which maximizes total societal
utils, and since often that one will provide gargantuanly more total societal
utils than the Pareto one, or make 99+% of the people better off than the
Pareto one, well, call me funny, but that might be something people might want
to know about, other than being kept blind to any option but two, Pareto and
status quo.

In any case,
whatever our values, and if the analysis is being completely positive, and just
exploring and giving information on options of interest to the public, with no
endorsement, it is not intelligent, or realistic, to not consider carefully how
the real world differs, and behaves differently, from the model. And this is especially
true with a model as extremely unrealistic in very material ways as Wallace's.

So, let's
consider this here.

Wallace works
because people see what the government is going to do in every possible state
of nature perfectly, and respond with their plans perfectly to the QE. Again, I
have to dwell on this, because it's frighteningly, and maddeningly, absurd to
see economists at top universities taking this literally, or highly literally –
And yes, many of them are not that stupid or detached from reality. For many they
say this to make their hard won specialization more valued, or to make their
right-wing ideology sound more attractive to the public, to the policy makers
and the voters.

But it should
be obvious, if you've lived beyond childhood not detached from the world, that
almost no human is anywhere close to like this. And the vast majority are very
far. Just one example, which should come as little surprise: People were recently
surveyed on what percentage of the federal government budget is foreign
aid. Now, these are the people who supposedly know government spending so well
that they always respond perfectly in their consumption and investment plans to
any change; or expected change. On average, they overestimated it by 28-fold!
And it's not 28 times a trivial amount. Actual foreign aid spending is just
under 1%, and the average estimate is 28%, of government spending!

And it's not
just some outliers skewing the average. Only 4% of those surveyed answered in
the correct range, 0-1%. Only 29% gave an answer that was off by less than
10-fold.

Paul Krugman wrote in his 1994 book, Peddling Prosperity:

Does this argument sound
convincing? It did (and still does) to many economists. Akerloff pointed out,
however, that it depends critically on the assumption that people do something
that they are unlikely to do in real life: take account of the implications of
current government spending for their future tax liabilities. That is, the
claim that deficits don't matter implicitly assumes that ordinary families sit
around the dinner table and say, "I read in the paper that President
Clinton plans to spend $150 billion on infrastructure over the next five years;
he's going to have to raise taxes to pay for that, even though he says he
won't, so we're going to have to reduce our monthly budget by $12.36...the
truth is that even families of brilliant economists don't have conversations
like this. (page 208)

So the vast majority, to the extent they're aware at all of a QE, are not
going to explicitly change their consumption and investment plans – to the
extent they even have them – to counter the government's QE.

But what about sophisticated investors? What about actively managed funds,
which have some of the savings of the unsophisticated?

It is often counter argued that you don't need every investor to be
rational. As long as you have some marginal investors who are rational, then
they will be enough to push prices all the way to efficiency, all the way to
what the model says. My reply to this argument is as follows, with the first
points being more general, followed by those more specific to the Wallace model:

Why a minority of savvy
investors at the margin is not enough to push prices to efficiency

1) Enormous, Profound, and Widespread Inexpertise and Ignorance – We
always hear the issue as being rational vs. irrational. Well, I could be 100%
rational and logical, but if you ask me my opinion on the construction of a
nuclear power plant, I will give you some extremely sub-optimal advice. Why?
Duh, because it's far more than rationality; it's usually far more expertise
and information. No matter how rational I am, I'm incredibly inexpert on making
decisions on nuclear power plant design, and have comically little of the information
important to making those decisions.

Again, should be ridiculously obvious, yet the discussion in academic
economics and finance is always about rationality. Is there some Harvard evolutionary
theory that shows how people can be tricked to think and act irrationally in
some way, sometimes. Well, this may be fancy and intellectual sounding enough
that you can get it published in a top journal, and avoid grievous career
punishment and get big career rewards, but it's usually nothing compared to the
typical person's massive and profound inexpertise, ignorance, and
misinformation.

But that's not fancy enough sounding or otherwise acceptable to give as
an answer, or put in a paper, if you don't want the massive sticks or to lose
the massive carrots those with power in economics and finance academia wield.
So we ignore the pink elephant in the room.

2) Undiversification – A savvy investor is limited in how much he will
push the price of an asset to efficiency by how undiversified his portfolio
becomes as he buys more and more of that asset. This is a point that honestly I
have never heard explicitly stated in six years of intensive finance PhD study,
and much academic study after that. I got it published in a letter in The Economist's Voice (a journal written to be
accessible to policy makers, but edited by Joseph Stigletz and Brad DeLong).
Quoting myself:

...One reason which was missing,
at least explicitly, and which I have not seen yet in the literature, at least
explicitly, is that a smart rational investor is limited in how much of a
mispriced stock he will purchase or sell by how undiversified his portfolio
will become. For example, suppose IBM is currently selling for $100, but its
efficient, or rational informed, price is $110. It must be remembered that the
rational informed price is what the stock is worth to the investor when added
in the appropriate proportion to his properly diversified portfolio of other
assets. Such a savvy investor will purchase more IBM as it only costs $100, but
as soon as he purchases more IBM, IBM becomes worth less to him per share,
because it becomes increasingly risky to put so much of his money in the IBM
basket. By the time this investor has purchased enough IBM that it constitutes
20 percent of his portfolio, the stock may have become so risky that it’s worth
less than $100 to him for an additional share. At that point he may have only
purchased enough IBM stock to push the price to $100.02, far short of its
efficient market price of $110. Thus, if the rational and informed investors do
not hold or control enough—a large enough proportion of the wealth invested in
the market—they may not be able to come close to pushing prices to the
efficient level.

3) The Limits of Arbitrage – This refers to the seminal paper, The Limits of Arbitrage by Andrei Shleifer and Robert W. Vishny. It really
involves "arbitrage" (vs. arbitrage, with no quotation marks). True
textbook arbitrage, by contrast, involves zero risk and zero upfront money, yet
you get money from the transactions involved, either now or sometime in the
future. The far more popularly referred to "arbitrage" is something
that makes an abnormally good risk-adjusted expected return, or is an
abnormally good risk-adjusted gamble, but does involve some risk (sometimes a
lot!), and possibly upfront money too. The use of arbitrage for "arbitrage",
as you might guess, is something that irritates me, and I think causes a lot of
confusion and misunderstanding. We really need a separate term for
"arbitrage". I actually like "arbitrage", as the quotation
marks give it the needed pejorative connotation for those who use it like it's
arbitrage.

In any case, the paper's main point is that if prices move away from
their efficient level, then there exists an "arbitrage" (and maybe,
but only very rarely, an arbitrage). However, the benefits of this "arbitrage"
may take a long time to appear. And, an "arbitrage" involves risk, so
even though ex-ante it's the smart move, there's usually a significant risk,
maybe even a large risk, that it will go badly or very badly ex-post.

Next, the paper notes that often wealth is managed by an agent, not the
principle. It may be a fund manager, an advisor, or a corporate officer, to
name a few. And this is usually because the principle has relatively little
understanding of, or information on, investments.[1] So, if a principle's agent
takes on an "arbitrage", this arbitrage may take a long time to do
well. In the short or medium run, it's not that rare for it to do badly, even
horribly. The agent can tell the principle, this is a long-term investment. In
the long run it will do well. But the principle will not know if he's lying,
given the principle's inexpertise and ignorance, so he may fire the agent and
sell the investment for a loss. Moreover, even if the principle is trusting and
patient, the investment may still ex-post do badly, or even disastrously. It
was only a good deal ex-ante.

The agent knows that he certainly faces these risks to his job, and
career, so he may play it safe and forgo the "arbitrage" for an investment
that he knows has a worse risk-adjusted expected return, but is well respected
among laypeople, and thus relatively safe for his job and career. Asymmetric
information may not exist in the typical freshwater model, but that won't stop
it from killing an investment manager's career – or for that matter, making
Americans pay horrifying costs for their healthcare compared to countries that
admit this reality (as well as rampant monopoly power, profound externalities,…)

The result is that lots of wealth will not be put into "arbitrage"s
by agents, limiting the forces pushing prices towards efficiency. Agents will,
of course, still take every bit of arbitrages they can get, as they don't even
need the principle for this. They can do it for themselves. Remember arbitrages,
as opposed to "arbitrages", require absolutely no upfront money, and
are absolutely zero risk.

Now, in the Wallace model, how would this affect the results?

Well, first, Wallace works because every individual is a superhuman
perfect expertise, perfect information, perfect foresight optimizer. So, no one
would pay to have someone else decide how to invest their money to start with!
And, on top of the fact that an agent would be unnecessary, he would also not
know your utility function perfectly. You could do it yourself better, in less
than a nanosecond, and perfectly, and at zero cost in effort, time, or money.

That is what the Wallace model, and the typical modern macro model,
assumes.

But, people do commonly hire agents, and have them manage a substantial
portion of their savings. Let's consider a fund, for example. The fund has many
participants. When the government announces the QE, the fund manager can't
perfectly counter the QE to maintain the same consumption path for all of its participants
in any states, because the transactions that perfectly counter the QE for
person i will be different than those that counter it for person j.

But, you may say: Well, each person can just go into the perfectly
complete markets and counteract the fund manager, by buying and selling the
appropriate combination of state-price contracts. Except, of course, we have
nothing close to these kinds of assets in actual financial markets. And the markets
are far from frictionless – from transactions costs to taxes.

I'll talk more about this agent-principle problem from "The Limits
of Arbitrage" later, with regard to other questions and issues.

4) Incomplete and frictioned markets, especially the inability to short
sell short at low cost, or at all – In Wallace, like in the typical modern
macro model, markets are perfectly complete and frictionless. And, you start in
equilibrium, with perfect efficiency. Suppose then, the government decides to
do a QE. They start buying a financial asset, and if they push the price up,
then it now has an abnormally low risk-adjusted expected return.

So, the savvy investors will have an incentive to sell their holdings
until the price goes back down again, so it's no longer a bad deal. But what if
the selling of the savvy investors, even completely exhausting all of their
holdings, is not equal to the government's buying at an elevated price? So the
price is not pushed all the way back to efficiency. Then, the next step the
savvy investors might want to take is to sell short. But if they can't, because
the asset is not sold short, then the savvy investors can act no further. The
price of the asset will remain above efficiency.

And in the real world it is common for assets to not have a short sale
market, or for the transactions costs of a short sale to be high. And, savvy
investors are still limited by their resources and credit worthiness, even when
a moderately-frictioned short-sale market exists. They have to be able to meet
the margin calls, for example.

5) Required equations (a) and (b) won't hold in the real world – Equation
(a) says that any monetary/fiscal operation, like a QE, must leave every single
citizen no better or worse off financially. That is, the net present value, at
the initial state prices, of their lifetime income and wealth must not change
as a result of the monetary/fiscal operation for Irrelevance to hold. In
addition, (b) says that any profit or loss from the monetary operation must be
100% foisted on the public, on the tax payers, by adding to or subtracting from
their transfers net of taxes.

But, of course, in the real world the government might not fully return
all profits to the citizens in reduced transfers minus taxes, and in such a way
that everyone has the same total net-present-value of wealth as before.

The government might take the profits from the QE and give them to
certain groups of people, but not others. Or, it may "consume" the
profits, to use Wallace's term, by spending them on infrastructure, or basic
scientific and medical research. Likewise, any loss from the QE might be
recouped by raising taxes predominantly on only some groups of people, like the
wealthy through income and estate taxes, or the poor and middle class through
payroll and sales taxes.

The main idea is that even if every person in the country is a perfect foresight,
perfect optimizing, super-cyborg savvy investor, the QE might not conform to
Wallace's requirements (a) and (b), and so their income paths and lifetime
net-present-value of wealth will change. Thus, as perfect optimizers, they will
then change their consumption and investment plans to accommodate. And this
will affect the demand for financial assets, and their supply, thus affecting
prices. So, this is another mechanism making Irrelevance not hold.

Of course, in the real world when the Fed does a QE, or any monetary
operation, the fiscal branches of government don't say to the public we guarantee
that any profit or loss from this QE will be returned to the citizens in
increased/decreased transfers net of taxes, and in such a way that no one is
any wealthier or poorer.

Clearly, this is far from what happens, and basically no one watches the
ultra-complicated government and political system very closely, or accurately,
and acts accordingly with their financial plans anyway. The average person thinks the federal government
spends 28% of its budget on foreign aid. The actual amount is only about 1%.

And even the extremely savvy minority of investors won't have this
information and ability in their heads. But even if they did, equations (a) and
(b) won't hold, so they won't keep their consumption/investment plans
unchanged, and so invest perfectly against the QE buying of the government.

And the profits from a QE can be substantial. Since the financial crisis
of 2008, the federal government has received over half a trillion dollars
in profits remitted by the Fed, and it looks like it could exceed one trillion before it's
over. Depending on how this money is used, it could certainly have a
substantial impact on demand, and the economy.

6) Investors cannot be sure if and when the QE will be fully reversed –
In the Wallace model, our cyborg investors know, with certainty, that all of
the dollars that the government is selling for C's, or financial assets, will
be purchased back again at a specific time in the future.

The plan is that these dollars will be sold by the government, then you
will buy some, and then the government will buy them back from you in the
future. And, if the price changes so you get a loss from this (which will be
the government's gain), then the government will fully compensate you for this
loss with increased transfers minus taxes.

And if the price changes in your favor, so you get a gain, compared to
your consumption/investment plan before the QE, then the government will fully
take that from you by decreasing your transfers net of taxes.

So, the public will want to buy what the government sells, so as to keep
their optimal consumption/investment path unchanged. They know the government
will buy it back, and will be compensating them personally for whatever profit
or loss this involves.

But of course, if they don't know that, then it's a very different story.
If they think that the government might not buy back their dollars, or all of
them; if they think that the government might permanently increase the money
supply, then they might not buy all of the dollars that the government is
selling at the current market price.

And in the real world, unlike in the world of Wallace, the public is not
certain that the government will be buying back all of these dollars from a QE
at some future time. So they will not act accordingly, as in the Wallace model.

But can Wallace neutrality
kind of work, to some substantial extent? Can it be a substantial factor?

The biggest real world factor I can see in the Wallace model is the
thinking, at least by some expert investors, or expert agents of investors,
that the Fed is likely to reverse the QE at some time in the not too far future.

If the Fed goes out and buys one billion ounces of gold, and expert
investors know that tomorrow the Fed will sell all of them back, then if the
price of gold rises by a substantial amount, you're going to see these expert investors
selling all of the gold they hold. If it rises more, they'll start really
short-selling it.

But with a QE, even expert investors can't be so sure when, or even if,
the QE will be fully reversed. So they certainly expose themselves to risk by
selling, and/or short-selling, into the QE. And the more they do it, the higher
the risk, as their portfolios become more and more weighted by their
short-positions, and thus, more and more undiversified, more and more exposed
to the little-diversified-away idiosyncratic risks in an increasingly
undiversified portfolio.

And the idiosyncratic risks can be very substantial, depending on the
assets.

Now, compare this one billion ounces of gold example to another example;
one where the Fed's QE is a lot more spread out over many financial assets, and
so they're only buying just 1% of the world's gold.

And suppose expert investors think that it will probably be at least 10
years before the government sells any of it back again. Furthermore, they think
there's a good chance that the government will never sell any of it back, or
will sell back only a small fraction of it.

Now, what if expert investors see the price of gold inch up from the government's
QE?

Are they going to say, hey, I'll keep short-selling with every resource I
have until the price of gold goes 100% back down again because gold is
over-priced?

Of course not.

Over a 10 year period having a portfolio composed entirely, or
predominantly, of gold-shorts would expose the expert investor to ridiculous idiosyncratic
risk! This would totally outweigh any benefit from gold having a somewhat
above-average expected return for its beta. And this isn't even mentioning the
principle-agent problem of "The Limits of Arbitrage".

So no, if the government does a large and a very unconventional QE, even
the expert savvy investors or agents are not going to sell into it nearly hard
enough to negate its effects on asset prices and inflation. And this isn't even
to mention the vast majority of investors who are not expert, and are just
basically oblivious to the QE, or grossly misinterpreting it.

And look at the current QE, or unusual monetary maneuvers. Already it's
been over seven years since the Fed began its large and unconventional
stimulus, and the balance sheet has only
grown, from
around $900 billion in 2008 to $4.5 trillion today. And no one thinks it will
wind all the way back to "normal" anytime soon.

So I would think that if the QE is very large and unconventional, it will
have a substantial effect. And it appears that's what the empirical research
shows. Ben Bernanke said in 2014, “Well, the problem with QE
is it works in practice, but it doesn’t work in theory”. Roger Farmer also wrote, "A wealth of evidence
shows not just that quantitative easing matters, but also that qualitative
easing matters. (see for example Krishnamurthy and Vissing-Jorgensen, Hamilton
and Wu, Gagnon et al). In other words, QE works in practice but not in theory.
Perhaps it's time to jettison the theory."

And this is with QE's that aren't inordinately big relative to the
economy. To those who say QE's cannot have an effect due to theory, that aren't
convinced by the empirical studies, I would ask do you still think a QE would
have no effect if we made it larger and larger. Would a QE of $10 trillion have
no effect? $50 trillion? 100?

How confident are you that this freshwater theory mirrors reality? And
how confident would you really be if you had to pay a big price for being wrong,
like the 99% who don't have jobs they can never lose, like tenured professors.

So, all other things equal, the longer expert investors think the QE will
last before it's substantially unwound, the less they will sell into it. And so
the more the effect from the QE. There's just more time to be exposed to idiosyncratic
risk from taking on a large short-position.

And, again ceterus paribus of course, the more unconventional the QE, the
less investors will sell into it. Because more unconventional assets usually
have higher idiosyncratic risk.

And the less sure expert investors are that the Fed will fully unwind the
QE, ever; that it won't, to some extent, be a permanent increase in the path of
money supply, the less they will sell into the QE.

And finally, with the Fed potentially handing over trillions in profits
to the fiscal side of government, it is possible for a QE to result in a large,
or much larger, fiscal stimulus. And to expert investors this fiscal stimulus
certainly could justify higher asset prices. Thus, the larger the forecast
profits to the federal government from a QE, the less expert investors will
sell into it

Next, we examine the important issue of reasons
why Wallace neutrality works in the model, as opposed to reasons people might incorrectly think are why
it works in the model, but in fact are not necessary.

Reasons why Wallace neutrality works in
the model, and not reasons why it
works in the model

Reasons why
Wallace neutrality works in the model

Each of these
are necessary, but not sufficient:

1) Perfectly complete
and frictionless markets – In the model, the government gives the citizens all
the incentive they need to buy what the government sells in a QE. The government
says any profits/losses from this QE will be 100% foisted upon you in
increased/decreased taxes-minus-transfers. We will be buying back all of these
dollars next period, and when we do, any profit or loss from this will come out
of your transfers-net-of-taxes.

Now, I've
talked about this extensively previously in this post/paper. The government
could give the whole profit/loss to just one citizen, or it could spread it
around however it wants amongst the population. It won't matter for Irrelevance
(Wallace neutrality) to hold.

But, to make
some points clear, let's suppose this special case: The government will be
printing 1 trillion dollars and using it to buy 2 trillion C's. We'll assume
the current market rate is $1 for 2 C's, or 50 cents per C. And suppose that
the whole profit/loss from this will be foisted on just one citizen, Mr. Jones,
who we will assume has no savings at all.

Well, for
irrelevance to work, Mr. Jones will have to be able to go short enough on C's
that he can buy every one of those one trillion dollars. And, in the end, when
the government reverses the QE, and buys back all of those dollars with its
stored C's, any resulting profit will be given to Mr. Jones. And he will use
that profit to pay off his shorting contracts.

Any loss to the
government from the QE, if one occurs, will also be foisted on Mr. Jones. And
he will pay this loss, perfectly, with his profits from his shorting contracts.

Thus, by doing
this, Mr. Jones guarantees that his consumption path will not change as a
result of the QE. And that's just what he wants, as a perfect-optimizing,
perfect-public-information, perfect-foresight, perfect-expertise,
instant-calculating, zero-calculation-cost-in-time-or-effort, cyborg. Which, of
course, everyone is.

As such, Mr.
Jones had already figured out that this consumption path optimizes his expected
utility, and he doesn't want it to change. Not when the net-present-value of
what he has to work with, his consumption path possibilities set, hasn't
changed as a result of the governments plan to do a QE.

And it hasn't. The
government is buying and selling at the market prices. It's buying a bunch of
stuff at the current market prices, and then selling it all back at the same
future market prices given the future state. So the net present value of all this
is zero, discounting at the current state prices.

If you tell
someone I'm going to take some of the dollars I've promised you, buy an ounce
of gold with them for you, then I'll hold your ounce for one period, then sell
it, and give you what I get. Then your wealth hasn't changed, if markets are
complete and frictionless.

Why? Because if
you don't like all this stuff that was done for you at the market rates, then
you can just undo it all at those same market rates with shorts. And you end up
exactly back to where you were, with the same exact cash flow paths, the same
exact consumption/investment possibility set.

And from there
you can change your paths and investments anyway you want at the market prices,
just the same as you could before the government did this. Your possibility set
has not changed. You can do all the same things you could before this
intervention, get all the same consumption paths over the states as before.
And, I talked about this earlier in the post in a more elaborate way.

But, for you to
be able to do this, the markets have to be complete enough for you to reverse
what the government has foisted on you. And you have to be able to do it with
no transactions costs.

Otherwise, your
consumption path possibilities set will change, and so you may choose a
different consumption path, and so different investments, and so you will put
pressure on the markets in a different way, and so the market prices will not be
the same, and so Irrelevance – a.k.a. Wallace neutrality – will not hold.

2) The
profit/loss from the QE is 100% returned to the tax-payers – There's zero
change in government spending as a result. So, as noted in our example above,
Wallace basically requires that we perfectly rig the game. Government has to
credibly promise any profit from the QE to the citizens in increased transfers
net of taxes. Otherwise, they won't have the incentive to completely take the
other side of the government's trades at the current market prices.

If the citizens
think they aren't getting those profits, that instead some of them will be
going to wasteful "government consumption" – you know, like basic
scientific and medical research, Heckman-style early human development investments,
and infrastructure – then the net-present-values of their endowments change. And
thus, their consumption path possibilities sets change. And, as a result, they
will choose different paths, with different investments, which will pressure market
prices differently, moving them from where they were.

3) Superhumans,
and that means everyone, not just a minority of savvy marginal investors –Everyone
has to have perfect public information and be perfectly rational. But it's much
more than that. What's more important, but almost always ignored, is perfect
expertise. You can be as rational as Spock, and have all of the information in
the world, but if you have very little understanding of finance, like almost
everyone, then you will be far from optimizing your investing – Or your medical
care for that matter. And you must employ this perfect expertise and
information instantly; zero cost in effort or time, or you're going to take
short-cuts in your analysis, use rules-of-thumb, and so forth. So everyone must
be an Ultron. And just having some savvy marginal investors who are Ultrons
won't bail you out.

As I've
discussed earlier, that an asset get mispriced means that its price is good or
bad for how it adds to a diversified portfolio. The price is good, say, for the
beta. It's a good deal only when added in the appropriate amount to your
portfolio. That makes it an "arbitrage", but it doesn't make it an
arbitrage. A minority of savvy investors won't keep buying it without limit,
because the more they buy, the more they get exposed to the assets idiosyncratic
risk; the more unbalanced their portfolios become. They're going to stop pretty
quickly. If the price of gold goes from $1,500/ounce to $1,600/ounce, with the
same fundamentals, the savvy investors of the world aren't all going to sell
all of their gold, and then if the price only drops to $1,590 short it with
every dollar they possibly can. The idiosyncratic risk is just too great. That
is not optimizing behavior for them.

And, there is
the principle-agent problem explained in "The Limits of Arbitrage".

So, everyone has to be an Ultron. Everyone
has to instantly respond to the QE saying, hey, the government's doing a QE; of
course, I know with certainty that they're going to 100% reverse the QE, and,
of course, when they do, 100% of the profit/loss will be remitted to the
citizens; and of that profit, I know exactly how much will be foisted on me,
and so I'll go out into the perfectly complete and frictionless markets and
100% counteract my chunk, taking the other side of the government's trades, so
that I keep my perfectly optimal consumption path for the current market prices.

It's just so
obvious the economy works this way. I don't know why it's even a discussion!

Not reasons why Wallace
neutrality works in the model, not
necessary

These reasons I
have seen put forward, or just thought of myself, as possibilities for why
Wallace neutrality might work in the model, but not in the real world. But it's
important to understand that they, in fact, are not specified in the model,
either explicitly or implicitly. And it's interesting that they aren't needed
to have Wallace neutrality in the model.

1)
Representative Agent – Everyone can be their own person. You're free to be you
– as long as you're an Ultron. You can have a unique utility function, and the
economy includes as many unique people as you want.

The basic
reason is that whatever utility function you have (with some completely mild
restrictions), Wallace rigs it so that it will be in your best interests to
either sit on the sidelines, or take the other side of the government's trades
at the current market prices.

The unique
individuals in the economy want to keep their optimizing consumption/investment
paths at the current market prices. And Wallace requires the government to
hoist the profit/loss from a QE on this population of individuals. And that
gives the hoistee's, no matter what their utility functions are, an incentive
to take the other side of the government's trades, so as to make sure that
their unique utility functions, whatever they are, stay optimized at the
current market prices.

2) Simple unrealistic
utility functions – Nope again, Wallace only requires very mild restrictions on
the utility functions: More income is better, the law of diminishing returns
sets in, and twice differentiable. Within that, it can be as complicated as you
want. The utility functions are not much of a source of consequential unrealism
in the model. That lies elsewhere.

3) Simple
unrealistic set of financial assets – Again, no. Markets are 100% complete, so
any asset you can imagine is included, or can be produced synthetically at zero
transactions cost as markets are also frictionless.

4) Closed
economy – Interestingly, it's not necessary. For Wallace neutrality to work the
government must credibly promise to foist whatever profits/losses result 100%
on investors in increased/decreased taxes net of transfers. This makes it
optimal for those investors to take the other side of the govenrment's QE
trades.

But the
government doesn't have to distribute the QE profits/losses to everyone in the
world. They can foist them on even just one of the seven billion people on
planet Earth, and it works. That one person takes the other side of all the
trades, borrowing and shorting as much as necessary in the perfectly complete
and frictionless markets.

So the fact
that the markets are international, yet investors in other countries are not
affected by U.S. tax and transfer policy makes no difference. You don't need
them to get enough money to take the other side of the U.S. govenrment's QE
trades.

Extensions – Ideas for new research
based on all of this

I hope I've
made it obvious at this point that there's no way Wallace neutrality will hold
in the real world. But the big question next is, how far from holding will it
be?

I could do a
theoretical model where we deviate from some of Wallace's assumptions and
formally prove that now equilibrium doesn't hold at the current market prices.
I could introduce a class of people who are not Ultrons, say, rule of thumb
investors; or goldbugs, people with an extreme lack of expertise and/or
information; or just normal people, who are people with an extreme lack of
financial expertise and information. And/or, I could relax the perfectly
complete and frictionless markets assumptions; I could introduce borrowing and
short selling constraints and costs.

It wouldn't be
hard in these cases to prove formally that equilibrium no longer holds if there's Wallace neutrality. Would
this be publishable? It depends on how much I could math it up nicely, and make
the math look long and impressive enough. I easily might not be able to. It
might just be too fast and simple to prove these things formally, and my
sketches of this seem to indicate this. And since I have no name, it's not
looking like that could get published.

But aside from that,
a big problem is that Wallace's model is really really general and vague. It's
basically just, people have utility functions – that's it! I mean, to get some
idea of how big an effect real world size deviations from the model have, you
need to introduce some kind of specificity, and hopefully calibration.

So, I think
what would be most useful would be to do a specific model with some calibration
to reality. Give people specific utility functions, say isoelastic, or
whatever's best, and calibrate the parameters to the real world. Then, look at
real world studies to see what percentage of people are rule-of-thumb savers
and investors, and put that in the model. Now, finding closed form impressive
looking mathematical solutions is going out the window, but is the goal to
impress with our math or be useful. Ok, let me rephrase that, should the goal be to be the most
useful to society rather than to most impress with fancy looking math?

If yes, then a
long time ago we should have been putting a lot of resources into constructing
elaborate and realistic economic computer simulations, where you don't get
closed form solutions, but you do get a lot more realism and precision. And I've
said
this for a long time. So, what I would want to do here is do a computer
simulation, where I give the citizens utility functions, and calibrate the
parameters to reality as best I can, and put in other specifics, and then just start
running it, trying various QE's, with various levels of non-perfection of
people and markets, and seeing how it affects things.

So, very
largely a programming project.

I have some
programming chops, and know some professionals who can help me, so maybe some
year, or decade, with my five minutes a week of free time…

As far as other
future projects. I think it was important to really explain all of this in
detail, and in as clear and easy to understand way as possible (for those with the
necessary considerable pre-requisites), so it was important to have a long
version. But, of course, few will read the long version. So next I'd like to
work on boiling it down, and then linking to the longer and better explanation.
So, on the agenda is a perhaps 1,500 word Intuition Behind Wallace Neutrality,
then 500 words, and even a two or three hundred word version. And, there's at
least a few specific related questions I'd like to discuss, like the long
awaited, and very interesting, answer to this.
Stay tuned…

[1] Yes, this is a case where inexpertise and ignorance are actually acknowledged,
and, in fact, pivotal, in a paper published in a top academic economics
journal. But, it's an exceedingly rare case. And its authors are famous Harvard
professors, who used clever math, and referred to a big mathematical model. If
you were much short of these things it would have been extremely hard and
unlikely to get this same exact insight published in an influential academic
journal.

"Richard Serlin, who has made himself one of the world’s experts on Neil Wallace’s original paper, was good enough to agree to write a guest post..." – Miles Kimball, University of Michigan economist, and one of the founders of New Keynesian Economics

"Richard Serlin (HT Mark Thoma) gives the bottom line intuition of Wallace neutrality... " – Bruegal blog, EU economics think tank, considered one of the best in the world

About Me

I am an adjunct professor for the University of Arizona where I teach one of the largest personal finance courses in the country, with over 500 students per year. I hold an MBA from the University of Michigan and have completed all coursework and written exams for a Ph.D. in finance from the University of Arizona. I am also president and co-founder of Summit Personal Finance Education, one of the country's largest U.S. Trustees approved providers of a personal finance course, designed by myself, which meets the requirements for bankruptcy filers under the BAPCPA law of 2005.

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Policy Note

I edit and improve most of my posts after I initially place them. I will not hesitate to do this, and without cross-outs, as my main goal is to teach and discuss clearly and well, to help with understanding and good idea creation, not to leave a historically accurate evolution of my writing. In fact, if you think the writing of a post has clunky spots or mistakes, you might want to try looking at it hours or days later. These things may be fixed, plus valuable new material may have been added. My writing really tends to improve with seasoning.

I will, however, note if I have made a major change of opinion, or corrected an important mistake of fact that could be substantially harmful to a person or party. This is subject to interpretation, however. For example, if the post was up for two minutes before I fixed it, I may not write a correction note. Unless my blog traffic greatly increases, it's unlikely many people, or any people, saw it.